What is the RSI indicator?
The Relative Strength Index (RSI) is an extremely useful and popular momentum oscillator – these are indicators of market momentum, based on the principle that as momentum slows, there are fewer buyers and sellers for the current price, in other words, volume decreases. This is the opposite for momentum for when price/volume action increases.
The RSI Indicator shows future probable changes of direction before trading actually reverses. This makes it a great way to start watching for a trade entry or exit.
This powerful indicator was developed J. Welles Wilder and introduced in his 1978 book, New Concepts in Technical Trading Systems. There are a couple of other well-known trading strategies that employ the concept ‘Relative Strength,’ so don’t get confused with them, and just talk about the RSI.
The RSI Indicator measures the ratio of moves higher to moves lower in a specific period. Wilder preferred a period of 14 (minutes, hours, days, etc.). up-moves to down-moves. The RSI index is expressed in a range of 0-100.
Readings of 30 or lower indicate the probability of the currency pair’s being oversold, meaning that it’s gone just about as low as it can, and so there ’s a reasonable likelihood of the price going up. Readings of 70 or higher indicate the probability of a currency pair’s being overbought, meaning that it’s gone about as high as it can, so the price is likely to come down.
How the RSI Indicator works
There are two equations used in calculating the RSI reading. The first equation calculates the initial Relative Strength (RS) value, which is the ratio of the average ‘Up” closes to the average of ‘Down’ closes over ‘N’ periods represented in the following formula:
- RS = Average of ‘N’ day ‘s closes up / Average of ‘N’ day’s closes down
The second equation provides the number that the trader will use to make decisions. It is calculated by indexing the indicator to 100, through the use of the following formula:
- RSI = 100 – (100 /1 + RS)
But you don’t need to make this calculation. On your forex trading platform, you’ll find an RSI indicator all ready for you. You just have to click on it to get the number you need to make trading decisions.
Trading with the RSI
Readings below 50 show the currency pair hitting the support floor level, and above 50 show the price rise meeting resistance. Obviously, readings well below 30 or above 70 indicate a stronger probability of a reversal. Remember: Nothing is certain in forex trading, but having the RSI on your side, along with another trend indication strongly suggests that you should take action, according to your trading strategy.
Using Two RSI Readings at Once
There will be different RSI readings depending on the period you choose to apply. The default setting is 14 periods (the one Welles Wilder, its inventor, liked).
But the 14 period setting doesn’t react as quickly to trend reversals. So try a 5 period reading instead. This will give you a faster trend indication, but one that may not be long-lasting.
So here’s the trick: Use two RSI indicators at once. You set up the RSI with a 5 period and an RSI with 14 period settings. When the 5 period RSI crosses the 14 period RSI, you have a rising price action. When the opposite occurs, you have a decline.
RSI Classic Divergence
The RSI Classic Divergence is another well-known indicator of a trend reversal. This one is a bit complicated:
1) The currency pair price hits a lower low – this means it has hit the support floor, then gone up, then gone below the support floor price;
2) The RSI diverges, however. It also hits a low, but then it makes a higher low;
The divergence of the RSI from the price movement is again a strong suggestion of a trend reversal. The example above shows a bullish divergence.
The same technique works, of course, for what is called a bearish divergence. In this case, the currency pair makes a higher high, but the RSI drops to a lower high, suggesting that the rising trend is weakening and a drop in price is coming.
Many traders work with classic divergence for trade entry and exit. It is a relatively low-risk method to sell near the top or buy near the bottom.
As you gain experience in trading, you will find that there are many other ways to work with the RSI. It is a kind of old reliable for forex, and particularly when combined with other indicators, it is very useful.